Understanding The Housing Bubble – Everything You Need to Know
The possibility of a housing market crash has been one of the most widely discussed topics in the country ever over the past few months. Data shows that an increasingly large number of Americans are concerned about the state of the housing market as well as the economy in general.
Data from Google Trends shows that the number of searches for the terms ‘housing bubble’, ‘housing crash’, and ‘will the housing market crash’ have increased exponentially in recent times to a level never witnessed since Google started reporting on its search trends back in 2006.
What does it all mean? How do we make sense of the data available? What exactly is going on in the housing market? Let us address these important questions through this comprehensive guide that will inform you of everything you need to know about housing bubbles and how to navigate them.
What is a Housing Bubble?
A housing bubble is a market condition which is marked by an unusual, unreasonable, and unsustainable increase in the price of residential real estate. It’s a temporary event which can last for several months to a couple of years, after which it eventually bursts, which in turn results in a steep decline in home prices.
Depending on the circumstances, the impact of a housing bubble might not be limited to the housing market alone. The best known example of a housing bubble with far-reaching consequences is the Barney Frank housing bubble that formed in the mid 2000’s, which triggered the subprime mortgage crisis and led to the Great Recession.
What Causes a Housing Bubble?
Real estate prices tend to go up whenever demand outpaces supply. Under normal circumstances, the supply side eventually catches up with the demand, which causes home prices to go down – a phenomenon commonly known as correction.
A bubble, on the other hand, is formed when the demand is not organic, but driven by external factors. For instance, one of the biggest factors that contributed to the housing bubble in the mid 2000’s was the loose lending and underwriting standards, which made it easier for almost everyone – even those with poor credit history – to get a mortgage.
Low interest rates and mortgage products with low down payments can also make home ownership more affordable, as a result of which more people – including those who might not have been able to afford a home before – to enter the housing market.
As more and more people enter the market, demand tends to outpace supply very quickly and home prices are artificially inflated as a result.
More importantly, loose lending standards and the increase in demand lead to speculative investing – a phenomenon where people invest in real estate based on unrealistic home price appreciation estimates. It can also lead to a phenomenon called FOMO (fear of missing out) purchases – which involves people buying residential properties in the hope that the prices will continue to climb higher.
One of the most notable aspects of a housing bubble is that the average homebuyer tends to get priced out of the market by speculative investors, flippers, and institutional investors, who can afford to invest in overpriced properties.
Factors that Cause a Housing Bubble to Burst
A housing bubble can burst due to a wide range of external factors. The most common factor is a sudden rise in interest rates, which can impact the housing market in two ways.
- First, the increase in interest rates can increase the cost of home ownership, as a result of which many people might not be able to buy a home. It can lead to a decline in demand, which in turn can cause home prices to go down.
- Secondly, the increase in interest rates tends to translate into higher monthly payments for homeowners with adjustable rate mortgages. It can cause tremendous financial distress for homeowners – particularly those with low to moderate income – and lead to a sharp increase in defaults and foreclosures. These foreclosed properties can add to the supply of residential properties available on the market and reduce the gap between supply and demand to a great extent.
Inflation is also a key factor that can contribute to a housing market crash. If inflation rate climbs to unprecedented levels, people might struggle to meet their day-to-day expenses and might not have sufficient disposable income left to make their mortgage payments.
Recession is yet another factor that can cause a housing bubble to burst. Whenever the economy is in recession, unemployment rate tends to increase. People who get laid off might not be able to make their mortgage payments, which can result in an increase in defaults and foreclosures.
Moreover, during an economic contraction, even those who are employed might be worried about the possibility of getting laid off, as a result of which they might postpone their plans to buy a home. As a result, the demand for residential properties tends to stagnate, while supply continues to increase – resulting in a sharp decline in home prices.
Impact on Lenders and Homeowners When a Housing Bubble Bursts
When a housing bubble eventually bursts, home values tend to plummet to unforeseen levels. The consequences of a steep decline in home prices can be two-fold.
First, lenders might find themselves in a situation where the homes they financed are not worth the amount they loaned to the buyers. To limit their losses, they might decide to tighten their lending and underwriting standards, as a result of which many people might no longer qualify for a loan.
Secondly, homeowners might find themselves underwater – a situation where the value of their home is lesser than the amount of money they owe the lender. It’s also known as being in a negative equity position, since the loan amount is greater than the built-up equity.
Depending on the circumstances, the bursting of a housing bubble can lead to a significant reduction in overall economic activity and lead to a recession or crash.
Are We Currently in a Housing Bubble?
Now, the million dollar question is – are we in a housing bubble, and if so, how similar is it to the bubble that precipitated the Great Recession back in 2008? The short answer is: yes, we are in a bubble, but things are probably not nearly as bad as they were back in the mid 2000’s.
Fannie Mae’s Home Purchase Sentiment Index (HPSI) shows that consumer confidence in the housing market has cratered, as an increasingly large number of people are concerned about not being able to buy a home and are pessimistic about the overall market conditions.
The reasons are not hard to find. Inflation is at its highest level in a very long time, the cost of essential commodities like meat and gas has increased significantly, mortgage rates have increased sharply, and people have less disposable income – all of which has made it next to impossible for the average person to buy a home.
Does the Current Housing Bubble Resemble the One That Caused the Great Recession of 2008?
Some economists believe that the housing bubble we are currently in resembles the one that preceded the Barney Frank Great Recession of 2007-08 in several ways.
Home prices in the US have increased by more than 41% over the past two years, which is staggering to say the least. While the economy continues to generate employment opportunities, wages have not increased by any significant measure. A report from Moody’s says that regional housing markets in the US are overvalued by as much as 23%, which is certainly a cause for concern. But when you have some states doing well and high tax states pushing people away, you would think that the homes in the states where people want to live will continue to have strong home prices.
The gap between home prices and income levels continues to increase, which is one of the reasons why many economists believe that what we are witnessing right now is somewhat similar to the bubble that triggered the Great Recession that America never really got out of until 2017. Over the last year, home prices in the country have increased by more than 20%. During the same period of time, wages in the private sector increased by less than 5%.
The percentage of the average monthly mortgage payment to the monthly income of the average consumer is at a record high – similar to what it was during the housing bubble that led to the Great Recession.
Yet another worrying sign is the involvement of speculative investors and institutional investors in the market. Back in January 2021, the interest rate of the average 30-year fixed-rate mortgage was 2.65%. The record-low mortgage rates caused a large number of speculative investors, flippers, and institutional investors to jump into the market.
A report from the Joint Center for Housing Studies says that 28% of single-family homes in the country have been bought by investors. Another report shows that in the first quarter of 2022, investors bought up 20% of homes in major metros across the country.
The Possibility of a Correction in the Housing Market
Many analysts believe that a correction in the housing market is imminent and home prices are likely to go down by more than 8% over the next two years. In certain overvalued regional markets, the drop in home prices could be much steeper. If it does happen, it will be among the steepest declines in home prices ever recorded in a very long time.
The latest report from the Federal Reserve Bank of Dallas also says that home prices in the country are disconnected from market fundamentals to a salient extent and the housing market is behaving in an abnormal manner – similar to what we witnessed back in the early 2000’s – and a correction is most certainly on the cards.
Why a Housing Crash is Less Likely in the Prevailing Market Conditions
There are several reasons why many experts believe that a crash in the housing market is rather unlikely. These include:
Currently, demand continues to outpace supply in the housing market, as inventories are at a near all-time low and real estate developers are struggling to keep up with the demand. The possibility of supply outpacing demand is extremely low, as developers cannot get approvals as quickly as they used to get back in the early 2000’s.
Demographic trends in the US indicate that the rate of homeownership is likely to increase in the coming years. Millennials – who account for more than 21% of the population – are in their prime earning years. Data shows that Hispanic and Asian homeownership rates are at the highest level in over a decade and the trend is expected to continue in the coming years. With more and more people interested in buying homes in states that have fair tax policies, home prices are unlikely to fall to dangerously low levels – like they did in the past.
Most importantly, lending and underwriting standards in the industry are considerably stricter when compared to what it was like in the early 2000’s. Unlike what happened during the run-up to the housing bubble in the mid 2000’s, the post-pandemic housing boom was not fueled by predatory lending practices. Data shows that in the first quarter of 2007, mortgage debt service payments accounted for more than 7% of disposable income in the US Today, it is less than 4%.
Thanks to stricter lending practices, banks are in a much better shape now and are unlikely to be pushed to the brink even in the event of a correction in the housing market.
Even if home prices fall by 8% to 10% – as predicted by some economists – it cannot be considered a crash. A crash – by definition – is generally marked by a 20% drop in home prices. For instance, between 2006 and 2012, during the recession, home prices in the US fell by 27%.
Above all, experts believe that policymakers and regulators have learned their lessons from the Great Recession and are equipped to take the necessary steps to avoid the worst consequences of a correction in the housing market and its impact on the economy.
What is in Store for the US Housing Market Going Forward?
On the whole, the consensus among leading economists is that a correction in the housing market is a reasonable possibility. Based on this, it’s quite unlikely that this will lead to a massive crash in the housing market. The current situation is nowhere comparable to the state of the housing market and the overall economy back in the 2000’s. In the final analysis, investors must remain vigilant and live by the old wisdom of “Never say “never”” when it comes to predicting housing bubbles.
About the Author
Michael is the founder and President of Strategy Properties. Michael started his first company at the age of 19, while still a student athlete on a full scholarship to play basketball at the University of Detroit Mercy. Following two years of NCAA tournament play, Michael transferred to the University of Michigan to pursue a degree in Business Management. His natural-born passions in business have fueled his competitive drive to set high standards for himself and his companies.